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The Debt Market: Signs Of Life

September 30, 2007

To a central banker, getting a quick pop out of the stock market is a cheap parlor trick. Just cut interest rates more than people expect and...VROOM! Sure enough, the Dow Jones industrial average rose 336 points on Sept. 18 after the Federal Reserve cut the federal funds rate and the discount rate by half a percent each. It was the Dow's biggest one-day percentage gain since 2003. But the rally probably didn't impress Fed rate-setters.

What matters more for the U.S. economy has been happening elsewhere, largely out of the public eye. It's good news, too, though a bit more muted: There's growing evidence that parts of the debt markets that nearly shut down in August are coming back to life.

The recovery started even before the Fed cut rates as lenders gradually began to regain the confidence they need to extend credit. The damaged parts of the market are still fragile, and a large-scale blowup in the months ahead could still spoil things. But if the recovery continues, the renewed money flow might be enough to keep the economy out of recession. "It's too early to say the worst is over, but I'm optimistic," says Edward E. Yardeni, president of Yardeni Research Inc.

The progress is measured in increased issuance of out-of-favor securities, as well as falling interest rates for some borrowers. While some of the markets are obscure, improvements in their health translate directly into greater availability of financial products like home-mortgage loans. Across the credit markets, enthusiasm was palpable on Sept. 19, a day after the Fed cut rates for the first time since 2003. "The market is celebrating," said Lena Komileva, an economist at Tullett Prebon Group Ltd., a leading institutional broker.

The rapidity of the recovery in some hard-hit sectors is impressive. Take asset-backed commercial paper, which companies such as mortgage lenders issue to raise short-term funds. The market nearly melted down in August when buyers started worrying about the quality of the assets backing the debt, which can include subprime mortgages. Buyers refused to accept paper that matured in more than one day. Now companies are able to issue paper with maturities of up to six months. And the interest rates they pay are falling. From a high of 6.20% on Sept. 4, the yield on the top-rated paper with a one-day term fell to 5.27% on Sept. 19, a drop much greater than the decline in the federal funds rate.

The recovery has been less dramatic, but still significant, in the interbank lending market. At the height of the liquidity crisis in mid-August, even the biggest banks had to pay more for loans from each other because lenders couldn't gauge the risk of default. Meanwhile, investors fled to ultra-safe U.S. Treasury bills. That opened a gap of as much as 2.4 percentage points between the three-month interest rate known as the London Interbank Offered Rate, or LIBOR, and the lower yield on three-month T-bills. The gap, far wider than the typical half a percentage point, was a stark indicator of fear and doubt. But by Sept. 19, that yield spread had narrowed to 1.3 percentage points.

`A LITTLE MORE CLARITY'

Bidders are also gradually emerging in the obscure market for top-rated securities backed by credit-card receivables, with spreads vs. LIBOR narrowing to around 37 basis points vs. a crisis high of 50 and a good-times low of nearly zero, according to Jane L. Caron, chief economic strategist of Dwight Asset Management in Burlington, Vt. Investors are still shying away from the lower-rated parts of the market.

One clear indicator of recovery is that investors are making sharper distinctions between risky and less risky securities instead of trashing them all equally. "There's just a little more clarity out there now rather than people [acting] like deer in the headlights," says Frank Pallotta, a managing director in Morgan Stanley's (MS) fixed income division.

And while the damaged parts of the market are showing improvement, other sectors have never faltered. According to data collected by Thomson Financial (TOC), issuance of investment-grade corporate debt in August and the first half of September has continued at the same level as before the market crisis began—in the range of $80 billion a month.

Is the trouble over? Hardly. Mortgage defaults, the main driver of the credit-market crisis, are almost guaranteed to keep rising because of falling home prices and resetting adjustable-rate mortgages. "The mortgage financing market...is still fairly dysfunctional," says Larry Goldstone, president and chief operating officer of Thornburg Mortgage Inc. The difference now, says Joshua Feinman, chief economist of Deutsche Asset Management (DB), is that in August the Fed was fighting against the direction of a bearish debt market. Now, he says, the Fed is pushing the market a little more in the direction it's already heading.